Transcript of "Mafm the case for investing in dairy (2011)"

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Contents Executive summary 03 Demand side 05 Supply 12 Where can the world expand dairy supply? 16 Conclusion 26 DISCLAIMER Analyst Certification: Some parts of this paper reflect the personal views of Macquarie analyst(s) about the subject matter and no part of the compensation of the analyst(s) was, is, or will be directly or indirectly related to the inclusion of specific recommendations or views in this research. The analyst principally responsible for the preparation of this research receives compensation based on overall revenues of Macquarie Group Ltd ABN 94 122 169 279 (AFSL No. 318062) and its related entities (the Macquarie Group) and has taken reasonable care to achieve and maintain independence and objectivity in making any recommendations. This document does not constitute financial product advice and should not be relied upon as such. The information in this document is for discussion purposes only and is not an offer or solicitation to purchase or sell any securities or financial product. None of the information in this document takes into account any person’s personal objectives, financial situation or needs and you must determine whether the information is appropriate in terms of your particular circumstances. We recommend you obtain financial, legal and taxation advice before making any financial investment decision. The information contained in this document is strictly confidential. If you are not the intended recipient, you may not disclose or use the information in this document in any way. No liability is accepted for any unauthorised use of the information contained in this document. This document is not to be distributed to any person or corporation by the recipient. Macquarie Group Limited is the owner of the copyright material in this document unless otherwise specified. Macquarie Group Limited and its worldwide affiliates and subsidiaries accept no liability whatsoever for any direct, indirect, consequential or other loss arising from any use of this document and/or further communication in relation to this document. This document has been prepared based on information believed to be accurate at the time of the preparation of this document. Subsequent changes in circumstances may occur at any time and may impact the accuracy of the information in this document. Some of the information in this document and the figures that have been quoted, and or used within it, have yet to be confirmed and finalised and consent has not been obtained from all relevant stakeholders. It is important to note that to this extent the document may not be accurate or complete and some of the information could be subject to amendments. Any forecasts contained in this document are predictive in character and therefore no undue reliance should be placed on the forecast information. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The actual results may differ substantially from the forecasts and some facts and opinions may change without notice on the basis of changing market conditions. Past performance is no indication of future performance. Other than Macquarie Bank Limited ABN 46 008 583 542 (MBL), no Macquarie Group entity mentioned in this document is an authorised deposit-taking institution for the purposes of the Banking Act 1959 (Cth) and their obligations do not represent deposits or other liabilities of MBL. MBL does not guarantee2 or otherwise provide assurance in respect of the obligations of the Macquarie Group entities mentioned in this document.

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Executive summaryDuring the past three years, the grain, oilseed and outgrew demand and prices hit the floor. Wheremeat markets have received a significant amount prices came to rest on this floor in 2009 is anof attention. This can be attributed to accelerating important point to highlight in itself.demand from the biofuel sector and a surge in The new price ‘floor’ revealed in the aftermathglobal food and feed demand from emerging of the global financial crisis indicated that aeconomies which led to an unprecedented significant structural shift had taken place. Noincrease in most agricultural prices. Similar longer was the international dairy product pricestructural changes can also be seen in the global upside capped at just over $2,000/t, but this pricedairy markets. In rapidly developing countries, level effectively became the new floor post-2007.dairy products are facing unprecedented demandpressures from the emerging middle classes. The structural changes within the global dairyThroughout the developing world the emerging markets can be attributed to several importantmiddle class, higher incomes, urbanisation and factors, one of these being dairy demand inaccess to dairy retail facilities have all had a emerging economies. Growing levels of disposableprofound impact on the world dairy markets and is incomes across emerging economies has ledlikely to continue to do so for many years to come. to increased demand pressures on the available global dairy supply. If more people are demandingOceania dairy product export prices dairy products, and are willing to pay for them, higher prices are likely to follow. Additionally, rising input costs across all major dairy production regions have also contributed to a structural shift in the global dairy markets. A combination of higher feed grain, fuel, and land prices has led to a constrained incremental demand growth across the sector. It is also important to consider that the recovery of global dairy prices by early 2010 indicated that the market had moved from oversupply to balance.4 Throughout the global economic downturn poor returns in many dairy regions contributed to a significant decline in the global dairy herd. ItSource: United States Department of Agriculture (USDA), will take time and higher milk prices to recoverMacquarie production capacity lost over the duration of the financial crisis and to re-build the global dairyGlobal dairy markets have experienced many herd. It is anticipated that the return of dairyextremes in recent years.1 In 2007/08 dairy demand growth in 2010 will continue, and inprices rose to record highs, along with the fact there are already signs emerging of supplymajority of agricultural commodities. This rise constraints developing in the market.in dairy product prices was a direct result of Markets such as China and South East Asia aregrowing global economic prosperity.2 Like in most expected to provide significant opportunitiescommodity cycles, while the price boom did lead for dairy producers over the coming decadesto a surge in supplies it also acted as a natural as per capita consumption of dairy productsbrake on demand growth.3 Thus, when the expands throughout the region. Additionally, theglobal financial crisis hit at the end of 2008 the vast majority of countries in the world have dairyglobal dairy market, like many other commodity supply deficits which bode well for increasingmarkets, came under significant strain as supply consumption growth and dairy trade in future.1. Dairy Australia2. International Dairy Federation3. International Dairy Federation 4. Australian Bureau of Agricultural and Resource Economics (ABARE) 3

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Executive summary Most of the world faces a dairy supply deficit Source: Food and Agriculture Organisation (FAO), Macquarie4

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Demand sideThe global dairy markets cover an array of Demand inproducts including cheese, dry powdered milk,fluid milk, whey and yoghurts. This provides developed economiesdiversification for the market as different countries During the last decade dairy demand hasand different economic situations provide multiple remained relatively stable in the major developedlayers of demand for dairy products. Our analysis economies. Dairy consumption trends haveof FAO data, which looked at which countries become entrenched with per capita usage whichconsume what dairy products, revealed that the are already at very high levels. During the globalhigher a country ranks on scales of economic financial crisis incremental fluid and dry milkdevelopment, the higher both the volume and demand growth remained on trend. However,the diversification of dairy consumption. Thus, it demand for butter and cheese products fellcan be inferred that with economic development slightly, as high unemployment rates, highercomes not only more dairy consumption on a savings rates, and low consumer confidence ledvolume basis but also more consumption of to a decline in higher-end food product demand.5higher cost, higher value-add products such as Total milk product demand is yet to fully recovercheeses and yoghurts. back to the growth trend seen pre-recession.6Global milk product consumption – Once the Organisation for Economicexcluding fluid milk (tonnes) Cooperation and Development (OECD) countries’ demand improves, a higher milk price will receive further support. Currently high demand from emerging economies, combined with OECD demand recovery will put pressure on recovering global dairy stocks. Total EU/US/Oceania milk product demandSource: USDA (2009) Source: USDA, Macquarie Research (2010) 5. Dairy Australia 6. USDA 5

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Demand side The emerging economies are the key driver In emerging markets dairy demand has grown significantly while continued high unemployment and an unsteady economic recovery in the developed world has led to flat consumption growth in traditionally strong dairy consuming regions. Milk product consumption moves higher with GDP growth Source: FAO, Macquarie (2007) The strong economic performance of rapidly Chinas urban/rural dairy divide in 2008 developing economies, such as those in South America and Asia, have provided a solid underpinning to the global dairy markets in 2010, a trend which appears to be accelerating. The key areas of dairy demand growth are centred in East Asia, South East Asia, South America and the former Soviet Union. The emerging middle classes in these countries are becoming more health conscious and with increased spending power are willing to pay more for higher-end dairy products. Source: USDA Attache, Macquarie Research, (January 2011)6

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It is anticipated that demand for milk will continue have higher bone density levels thus loweringto rise in line with the growing global population risk of osteoporosis later in lifeand the industrialisation and urbanisation process  Immune protection – studies suggest milk’sunfolding across the developing world. Across whey component provides glutamine andemerging markets it is evident that a young, lactoferring, which studies show may offerurbanised population is altering their dietary immune protectionpatterns, demanding more higher-value food  Digestion – milk’s whey protein can helpproducts and moving from lower to higher-value provide amino acid glutamine which, whenfoods including dairy and meat products.7 In fact, lacking, has been shown to cause upsetdata available on the divide between urban andrural per capita milk consumption in developing stomachseconomies clearly illustrates that rural populations  Exercise recovery programs – scientistslag far behind their urban counterparts.8 have demonstrated that dairy products such as chocolate milk are an effective exercisePer capita milk product consumption, 2010 recovery aid due to their combination of carbohydrates and protein. Dairy products are the richest and most effective source of calcium in the diet and cannot easily be substituted by other sources.10 According to the United Nations (UN) World Health Organisation (WHO), diets that are low in dairy products will generally not provide sufficient calcium, which is particularly vital for the proper development of young children.11 The UN considers that milk consumption is a key variable to combat malnutrition and has committed significant resources to establishingSource: Food and Agricultural Policy Research Institute school milk programs in developing countries.12(FAPRI), USDA, Macquarie (2010) For adults milk consumption is routinely cited as a key factor for the prevention of osteoporosis.Health benefits of dairy An increasingly urban world population boostsDairy products are an important source of several demand for milk productskey nutrients. Outlined below are several provenhealth benefits of milk consumption9: Essential nutrients – protein, carbohydrates, fats, vitamins (A, B12, and riboflavins), and minerals (calcium, phosophorus, magnesium, potassium and zinc) Blood pressure – milk products are high in potassium, magnesium and calcium; minerals which may help lower blood pressure Healthy bones – dairy foods are the main providers of calcium. Consumption of milk products has been shown to improve bone density and prevent osteoporosis. Studies of children have shown that those who have Source: FAO Secretariat, Macquarie consumed adequate amounts of milk products7. UN Secretariat, Macquarie Research Economics 10. USDA, Dairy Australia, UK Food Standards Agency, National Dairy Council,8. USDA FAS Attaché UN WHO, International Dairy Federation9. USDA, Dairy Australia, UK Food Standards Agency, National Dairy Council, 11. UN WHO 7 UN WHO, International Dairy Federation 12. UN WHO

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Demand side The UN forecasts that the global population will reach Currently, China’s per capita dairy consumption 9.1 billion by 2050; a growth of 33 per cent from is 12.3kg/capita, 86 per cent below current today’s population of 6.9 billion. The UN also predicts United States (US) per capita consumption.15 that an increasing proportion of the population will Over the next decade China’s per capita dairy be situated in urban centres. Today the world’s consumption is expected to rise by 160 per population is split roughly 50/50 between urban and cent.16 South East Asian countries such as rural dwellers. However by 2050, the UN forecasts Indonesia and Vietnam have also been identified this split will widen to 70 per cent urban 30 per cent as key consumption growth regions. Currently, rural.13 As increased urbanisation and growing per capita consumption stands at 1.4kg/capita in prosperity generates higher disposable incomes, Indonesia and 2 kg/capita in Vietnam. By 2019, more protein and processed foods are anticipated to per capita consumption is expected to grow be consumed. In fact, in many regions consumption by 76 per cent and 34 per cent respectively.17 of dairy products is still considered a luxury, however According to these figures, per capita this is rapidly changing as milk products are consumption across the world, and particularly becoming a dietary staple.14 Urbanisation allows for in South East Asia, still has tremendous upside easier marketing and distribution of dairy products potential for the future. to consumers as people have greater access to distribution and cold storage, along with greater Three stages of accelerating milk choice through large retailers and restaurant chains. consumption growth in emerging markets Comparative consumption trends In many developing countries per capita milk consumption remains far below North America and Europe. The graph, Comparison of per capita milk consumption across the world, highlights the growth potential inherent in the world’s dairy markets. Countries such as Brazil, India and Mexico are approximately mid-way up the demand curve but have further upside growth potential over the next decade. On the lower end of the scale countries such as China, Venezuela and South East Asia have only begun to consume increased quantities of milk which could potentially lead to large upside growth over the coming decades. Source: USDA, Macquarie Comparison of per capita milk Total milk consumption (including all products) in consumption across the world the three major dairy growth markets of South America, South East Asia and East Asia has been accelerating. The chart, Three stages of accelerating milk consumption growth in emerging markets, depicts three distinct growth phases. First, from 1964 to 1981, milk consumption growth was constrained by underdevelopment in these economies. Consumption growth still managed to surge 62 per cent but came from an extremely low baseline. Second, from 1982 to 1993 many of these countries saw increased rates of development with milk consumption growth at 49 per cent over the period. The third Source: FAPRI, USDA, FAO, Macquarie and current stage running from 1994 to present 15. FAPRI8 13. UN Secretariat 16. FAPRI 14. KPMG 17. FAPRI

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has seen a 128 per cent surge in consumption as Indonesia is not the only country facing growingthe industrialisation process is undertaken.18 It is import requirements. In 2010 Russia’s droughtdifficult to gauge how long this process of strong disaster diminished total grain production by overlinear year-on-year growth in demand will continue, 35 per cent from 2009.22 This led to soaringhowever, judging from the comparative per capita domestic feed prices which in turn causedconsumption data across different countries, increasing livestock herd liquidations.23 Althoughincreasing prosperity will likely continue to act as a China will be the largest importer of fluid andstimulant for increasing dairy consumption growth. dry milk, Russia will remain the world’s largest importer of all milk products in 2010. TotalIndonesia’s dairy market is an example of the demand is expected to grow by 10 per centpotential for dairy market growth in South in 2010 from 2009. This large dependency onEast Asia. Between 2000 and 2010, Indonesia imported milk products will take time to reduceexpanded milk production by 35 per cent, despite the Russian government’s current five-producing 1.06mt by 2010.19 However, demand year plan to promote the development of thegrowth also doubled over this period. In order domestic livestock and poultry industries.24to meet this demand, major dairy exporters Total dairy product importersNew Zealand and Australia have had to supply (includes fluid/dry milk, cheese and butter)much of the additional demand needs in theform of dry milk powder.20 Indonesia’s wholemilk powder imports have surged 187 percent between 2000 and 2010, while non-fatdry milk imports are up 170 per cent.21 Giventhis, the outlook for Gross Domestic Product(GDP) growth over the next decade coupledwith constraints on expanding domestic dairyproduction – in line with demand growth –means Indonesia will continue to be a significantand growing net importer of milk products.Indonesian milk consumption vs GDP growth Source: USDA, Macquarie China has become the world’s largest importer of fluid and dry milk products and will continue to be the dominant force in the global dairy markets. Growth in China’s milk product demand presents a significant opportunity for dairy producers. As outlined in the subsection regarding China’s dairy industry, strong import demand growth has been fuelled by consumer mistrust of domestically produced milk following the 2008 melamine-tainted milk crisis. Imports reached 335mt in 2010, tripling import levels in 2008.25 China simply cannot supplySource: USDA, Macquarie all of its milk product demand needs.18. USDA 22. USDA19. USDA 23. USDA FAS Attaché20. USDA 24. USDA FAS Attaché 921. USDA 25. USDA, Macquarie

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Demand side Despite attempts by the Chinese Government to encourage domestic dairy production, the general view is more supportive for an increasing China milk import demand program. Cash corn prices in China are now at record highs having increased 35 per cent between early 2009 and late 2010.26 A surge of feed and industrial corn demand in the absence of significant supply growth has led to internal shortages and imports of US corn for the first time in more than a decade. With flat corn yield growth and limitations on arable land expansions, it appears China will continue to struggle to produce enough feed grains domestically to support a growing dairy herd, along with other livestock and poultry supply growth. Soy meal prices have also increased nearly 10 per cent between 2009 and 2010 as feed demand requirements continue to significantly expand soybean imports.27 These feed cost pressures, along with limitations on dairy production expansion – due to disease and a lack of water resources – should prove conducive to continued milk import demand growth28. Major dry/fluid milk importers Source: USDA, Macquarie 26. Thompson Reuters 27. Thompson Reuters10 28. USDA

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China’s melamine crisis offers opportunitiesto milk producers in exporting countriesIt has been a slow road to recovery for China’s domestic dairy production industry following the 2008melamine-tainted milk scandal. Immediately following the crisis, demand for domestically producedmilk products plummeted causing a 17 per cent reduction in the size of China’s dairy herd between2008 and 2009. Total demand recovered quickly, however, consumption was then fuelled by dairyimports, not local production. This caused total milk product imports to surge 210 per cent between2008 and 2010. This import surge was led by dry milk powder products due to very strong demandfor infant formulas and it appears this trend will continue at least until the Chinese dairy herd sizemakes a full recovery.According to the USDA, China’s dairy herd size is increasing once again as demand for domesticallyproduced milk begins a slow turn-around. The government has adopted stringent melaminecontamination prevention measures while continuing to subsidise dairy production at the farm level.The Government’s dairy plan sets a target for 48mt of milk production by 2013; nearly double currentproduction levels. However, this target may turn out to be optimistic due to continued consumer safetyconcerns, extremely high feed costs, and a growing incidence of disease outbreaks such as Foot andMouth Disease (FMD). Therefore, although China’s dairy herd is projected to have grown seven per centbetween 2009 and 2010, dairy product import demand has grown at a much faster pace of 38 per centover the same period. It may take many more years for the domestic dairy sector to make a full recovery.In the meantime it is highly likely China will remain the world’s largest market for dry milk powder exports.Total dairy product importers Total dairy product importers(includes fluid/dry milk, cheese and butter) (includes fluid/dry milk, cheese and butter)Source: China Statistics Bureau Source: USDAAccording to the China Statistics Bureau, monthly dairy product output (a good proxy for demand)recovered back to pre-crisis levels by late 2010. Total output has already reached 15.6mt from Januarythrough September 2010, up nine per cent from 2009. China’s dairy consumption growth is beingfuelled by higher disposable incomes, increasing health consciousness, and greater access to dairyproducts at the retail level. Over the past decade China’s total milk product demand has increasedover 340 per cent29. However, on a per-capita basis, China’s total consumption still lags far behindthat of developed economies. Even more striking is the disparity in milk consumption between China’surban and rural populations. The graph, China’s urban / rural dairy divide in 2008 on page four, clearlyshows that per capita consumption of milk in rural areas is still only a fraction of what is currentlybeing consumed in urban areas. With China’s trend toward rapid urbanisation and an expandingmiddle class, the scale of milk consumption growth potential is indeed significant. This means China’sdairy market will continue to provide ample room for a solid growth in imports over the next severaldecades. This highlights the great opportunity which exists for the world’s major dairy exporters tocontinue gaining market share in China.29. FAO, National Bureau of Statistics China 11

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Supply Global dairy production has remained on an Global dairy herd vs productivity upward trend over recent decades and more specifically over the last ten years to 2008; global milk production has increased on average by two per cent per annum.30 In contrast, for decades dairy herds globally have been in structural decline shrinking 28 per cent between 1984 and 2009. In fact, the global dairy herd declined to 124.7m head by 2009 after a short- term peak in cattle numbers in 2008 at 126.5m head. In 2010 the dairy cattle supply stabilised at 125.5m head, up 0.63 per cent from 2009 following a recovery in international dairy prices and improving import demand. Global milk production Source: USDA It is also important to look at the dispersion of dairy cattle herds globally. From the late 1990s to 2010, the world’s major traditional dairy exporters saw a 10 per cent decline in overall herd numbers. Between 2009 and 2010, the economic slowdown accelerated this trend with dairy cattle numbers falling 1.6 per cent. In 2009 and early 2010 slow demand growth in developed countries, combined with weak export markets, contributed to weak dairy producer margins in Europe and the US, which in turn led to herd reductions. Of this group, only New Zealand realised herd growth over the 2008 to 2010 period with four per cent growth registered Source: Macquarie Research (November 2010) between 2008 and 2009 and another 2.4 per cent growth between 2009 and 2010.32 Productivity per animal has improved markedly over the past few decades due to improvements in dairy farming practices including more scientific feed rations, industry consolidation (economies of scale) and improvements in dairy health. In 1965 the world average milk produced per cow in one year stood at 2.1 tonnes per year improving 13.4 per cent to 2.48 tonnes by 1985. By 2010 the average was 3.5 tonnes, a total increase of 60 per cent from the 1965 level.31 The boost in efficiency and productivity has contributed, in part, to the decline in the total world herd size while keeping total milk production on a steady uptrend. 30. USDA, FAO12 31. USDA 32. USDA

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Major milk exporters’ dairy herds shrinking In terms of overall dairy production, Europe and North America are the largest dairy producing regions, making up over 50 per cent of the total world production.34 Due to the high population base in the US and European Union (EU), these dairy markets are focused mainly on internal market dynamics. Dairy is a thinly traded agricultural commodity as many countries are focused on maintaining internal balance with only a few major players involved in export markets. Only between seven and eight per cent of total global milk production is traded internationally.35 World milk production by region in 2010Source: USDABeyond the traditional dairy exporters, dairy herdshave also been increasing in South America, andmore specifically Brazil. Although dairy exportshave been increasing from South America,strong rates on internal milk consumption haveprevented South America from becoming a majorplayer in the world milk trade.33 Although therewill be many constraints on dairy herd expansionmoving forward, global dairy herd numbers arepredicted to begin stabilising into 2011 and mayeven gradually increase. Source: USDA (2010)Global dairy herd Fresh milk is a highly perishable good which means most countries with high levels of dairyMillion head 2005 2006 2007 2008 2009 2010 consumption also have high levels of dairyIndia 38.00 38.00 38.00 38.50 38.00 38.50 production. Thus, international dairy trade isEU 25.36 24.94 24.18 24.18 24.19 23.66 dominated by products with a longer shelf-lifeBrazil 15.10 15.29 15.93 16.70 17.20 17.60 such as powdered milk products, primarily skim-FSU12 14.53 13.74 13.13 12.90 12.39 12.17 milk powder (SMP) or whole milk powder (WMP).United Combined, these products make up the bulk ofStates 9.05 9.14 9.19 9.32 9.20 9.12 international dairy trade at 21 per cent and 26 perChina 6.80 7.90 8.76 8.58 7.12 7.63 cent respectively. Cheese and butter productsNew comprise the balance at 25 per cent and 21 perZealand 3.97 4.10 4.16 4.20 4.37 4.47 cent respectively. Fluid milk exports, however,Argentina 2.10 2.15 2.15 2.15 2.10 2.10 only account for seven per cent of global dairyAustralia 2.04 1.87 1.80 1.64 1.68 1.60 product trade.Canada 1.07 1.02 1.00 0.99 0.98 0.98Source: USDA 34. USDA33. Dairy Australia 35. Fonterra 13

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Supply World dairy product exports by type in 2010 Total dairy exports and production have been steadily increasing as regions which lack dairy production capacity have seen the strongest demand growth. Long-term trends in dairy exports from the three major exporting regions of the US, EU, and Oceania suggest that a solid upward trend remains intact. Total net exports from these three major exporting regions have increased on an average of one per cent per year over the past decade leading into 2010. Looking ahead, FAPRI estimates that net-export growth from the top three exporting regions will accelerate with average yearly increases of two per cent per annum over the next decade.37 Source: USDA (2010) Total net milk product exports Australia and New Zealand (Oceania) only account for six per cent of total world milk production however, these two countries provide over half of global dairy trade.36 Efficient, export-oriented production models, coupled with low domestic populations and proximity to key markets in Asia means this region has become the pivotal dairy supplier to world markets. The EU is the second largest dairy exporting region, accounting for 31 per cent of global dairy trade in 2010. World dairy exports by region as proportion of total world dairy trade Source: FAPRI, USDA (201) FAPRI’s data highlights another important trend in regards to export market share. Due to the competitive dairy production models in Australia and New Zealand, and proximity to key import markets in Asia, the share of Oceania milk product exports as a proportion of total net trade among the major exporting regions is expected to increase over the next ten years. Source: USDA14 36. USDA 37. FAPRI

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Per cent share of export marketSource: Macquarie Research, January 2011This will likely come at the expense of the higher-cost producers in Europe and the US. Australia isexpected to experience the greatest increase inthe share of total net trade, climbing 15 per centby 2019 compared to an 11 per cent share in2010. New Zealand’s share of dairy export tradeis also expected to increase to 48 per cent froma current 46 per cent. In contrast, it is anticipatedthat EU market share will decrease to 21 per centby 2019 compared to nearly 30 per cent in 2010.US market share is expected to remain relativelysteady near eight per cent, increasing only slightlyfrom a current share of approximately 7.5 per cent.These projections suggest that the countrieswhich already have established export-oriented,deregulated dairy industries will be able to benefitmost from emerging market demand. Australia,with a recently deregulated market, is expected toreceive a much greater share of the new importdemand emerging from Asia. 15

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Where can theworld expand dairy supply? Regional supply focus Average producer milk prices 2009 ($US/cwt) Growth in global milk supply can come about in two ways – either by increasing the global dairy herd and/or increasing productivity per cow. Increasing herd sizes requires significant investments at the farm level while increasing productivity per cow generally involves higher feed and management costs. Thus, there is usually a time lag between when additional supply is needed by the market and when producers will be able to increase production. Europe The European dairy production model can be Source: International Dairy Federation (2009) described as highly policy-oriented. Since World War II most major dairy producing countries in The EU also makes use of intervention purchasing Europe and now the EU forged a dairy industry programs to ease market surpluses. The common reliant on a complex government support reference to “lakes of milk” and “mountains of butter” program utilising subsidies, quotas, intervention in discussions over the EU’s Common Agricultural purchasing, and high tariffs.38 This has meant Policy (CAP) describes the EU historical policy of that internal EU milk prices have generally trended storing large amounts of these products as a price higher than international equivalent prices over support mechanism. This policy still exists but has much of this post-war period.39 evolved into more of a safety-net than a price support program with predetermined limits set on prices and These measures were implemented at various quantities offered into the intervention program.42 times in order to preserve internal market balance. The EU’s milk quota system was introduced In recent times the EU has again used the in 1984 to restrict milk production and control intervention program to ease excess milk supplies surpluses.40 However, the policy is expected which temporarily developed during the global to expire in 2015 which means the EU dairy financial crisis. Although EU intervention dairy industry faces considerable liberalisation over the stocks reached the highest level since 2003 by next decade. The likely restructuring of the EU the early months of 2010, stocks have decreased dairy sector is anticipated to align EU milk prices significantly as supplies are absorbed by the export closer to international prices over time (which and domestic markets. The EU Government’s dairy could translate to lower prices in the EU). While stocks continue to have an impact on wholesale the number of dairy farms will likely decrease, milk prices in the EU. With low butter stocks, farm sizes will increase to take advantage of wholesale butter prices have rebounded much economies of scale.41 However, because of the stronger than SMP prices. The gap between high-cost model of dairy production in the EU, it these two prices has in fact widened showing that is far from certain whether this liberalisation will the EU’s support programs continue to have a provide a situation which will lead to a significant direct impact on prices. Dutch butter prices have increase in total EU milk production. rebounded 83 per cent from the lows seen in 2009 to the highs in 2010 while SMP prices have only increased 40 per cent over the same period.43 38. Dairy Australia 39. DIN Consultancy 40. EAAE Seminar paper: Agri-Food and Biosciences Institute Northern Ireland, FAPRI, Queen’s University Belfast 42. Joint AES and SFER Conference ‘The Common Agricultural Policy Post 2013’ 41. EAAE Seminar paper: Agricultural Economics and Rural Policy Group, Paper presented by Alan Matthews, Trinity College Dublin16 Wageningen University 43. DIN Consultancy

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EU dairy wholesale prices Thus, even though the EU’s dairy herd is expected to continue declining over the next decade, increasing productivity will support slow incremental supply growth. FAPRI data suggests EU milk production should continue its slow incremental growth of 0.30 percent over the next decade, roughly in line with incremental demand growth.45 EU dairy balanceSource: DIN ConsultancyAs highlighted in the table, Global dairy herd, the EU’sdairy herd has shrunk significantly over the past fiveyears; declining 6.7 per cent or 1.7m head between2005 and 2010. Poor returns due to weak demandgrowth domestically and high feed prices hascontributed to the decline over the past five years.However, like most other major dairy producing Source: USDA, FAPRIregions, the EU is experiencing consolidation in theindustry as the number of farms shrinks while at the The EU dairy market could remain relativelysame time the sector is experiencing an expansion static, as a result of incremental supply growth,in farm sizes. Efficiency gains are driving this process over the medium term due to existing entryof consolidation. In the EU 4,723kg of milk were barriers (quotas), the distortionary impact ofproduced per cow in 1999 but this has increased various price intervention measures, and the1,000kg/cow or nearly 20 per cent by 2010.44 high costs associated with production. In the medium-term, increasing market liberalisationEU herd decreasing along with in the EU will provide efficient producers withproductivity gains an opportunity to expand production. However, there could be an extended period of adjustment to this liberalisation and to the higher feed grain price plateau which could result in temporary contraction and consolidation before the industry would be in a position to expand once again. However, at this point, the length and severity of the adjustment process is highly uncertain.Source: FAPRI44. FAPRI 45. FAPRI 17

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Where can theworld expand dairy supply? The United States The US dairy production system is highly intensive and heavily exposed to increasing feed costs. Milk is predominantly produced in consolidated feedlot operations which utilise large amounts of feed grains and protein meals. This milk production system can take advantage of economies of scale while the high-intensity feeding rations mean productivity per cow is much higher than the world average. In 2010 the average milk produced per cow in the US stood at 9.5t/year, this compares to 5.75t/year in Australia; 5.6t/year in the EU; and only 3.7t/year in New Zealand.46 US dairy farm concentration Source: USDA However, the major inhibitor to US dairy production growth going forward is cost. Whereas Australia and New Zealand can take advantage of a relatively warm climate and pasture-feeding year-round, much of US dairy production occurs in states such as Wisconsin which experience cold winters. Thus, the average US dairy operation is much more input-intensive, requiring more buildings, equipment, and feed as well as labour.47 46. USDA18 47. University of Wisconsin-Madison

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Productivity per cow US dairy production marginsSource: USDA Source: USDAFeed costs alone account for approximately 70 percent of total dairy operating costs in Wisconsin.48 A key determinant of dairy producer profitabilityAccording to USDA data dairy feed prices have in the US is the milk to feed price ratio. The milkincreased 69 per cent between 2003 and 2010. to feed price ratio trend has grown increasinglyThe drought in Russia during the summer of 2010 negative for US dairy farmers over the past decade.combined with disappointing US corn yields are a The following graph depicts the milk to feed pricereminder that significant grain price volatility may ratio since 1985 as well as an indicative rangepersist in the future. Accelerating feed grain and between which US dairy farmers typically begin toprotein demand from Asia and biofuel use worldwide, expand production. It suggests that since late 2007has proved difficult for livestock producers in the US there has been little incentive to expand dairy herdsto keep up with, due to heightened competition for significantly. It also illustrates that the current recoveryavailable supplies. This has pushed grain prices well in milk prices relative to feed prices still does notabove historical averages. indicate a solid milk supply expansion is imminent.49 The unfavourable milk to feed ratio will likely meanFeed prices increasing in the US that the US dairy herd will struggle to grow over the medium-term. To turn this situation around the US dairy market would need to see either a structural shift higher in milk prices internationally or a structural shift lower in feed prices.Source: Thompson Reuters48. USDA 49. USDA 19

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Where can theworld expand dairy supply? US milk:feed price ratio US monthly dairy cow slaughter rates Source: USDA Source: USDA Similar to the trend in all major dairy producing US dairy herd size falling; productivity growing regions, the US dairy herd has decreased over the past few years while productivity has increased. US dairy cow productivity is highly seasonal with peaks in the spring and troughs into the autumn. Average production per cow per month in the US has increased eight per cent between 2005 and 2010. Thus, despite the record monthly dairy cow slaughter rates brought about by the herd liquidations in 2009 and the early months of 2010 (shown above), total milk production did not fall significantly owing to these productivity gains.50 It is also important to remember that the US dairy industry operates alongside various government intervention programs including direct subsidies and Source: USDA intervention stock purchasing programs. The 2008 Farm Bill included even greater potential support These economic dynamics have had clear than previously existed for dairy farmers by providing implications for the size of the US dairy herd. US greater protection against decreases in milk prices dairy herd had previously posted consistent growth or feed cost increases.51 The dairy intervention stock rates, increasing by four per cent or 351,000 head program has receded somewhat in importance if between January 2004 and December 2008. By looked at from the basis of stocks (government and December 2009 the US dairy herd had peaked private combined) as a proportion of total domestic at 9.33m head. The herd decline has bottomed consumption. Compared to the heavy stock-build out near 9.1m head by late 2009 due to the poor seen in the early 2000s, the increase in dairy product margins outlined above. High dairy slaughter stocks through 2008 and 2009 never surpassed rates through 2009 and 2010 have reduced the 15 per cent proportion per total domestic demand, dairy herd by 2.3 per cent between 2008 and the compared to 20-25 per cent in the early 2000s. end of 2010. Improving margins into 2010 has led to a stabilisation of the dairy herd at 9.18m head. However, with the unfavourable milk to feed ratios it is unlikely that the herd size will increase 50. USDA20 significantly over the medium or even longer term. 51. ABARE

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US dairy product stocks This matching of production growth (roughly four per cent over the past five years) and consumption growth (also at four per cent) will very likely limit South American milk product export growth until the region’s per capita consumption rates begin to level off.55 This may take many years due to the high population in Brazil and other South American countries coupled with per capita consumption rates only half that of countries such as Australia and Canada. Balanced dairy market in South America provides little room for exportsSource: USDAAlthough the US dairy industry retains expansioncapacity through herd or productivity growth,higher costs of production and relatively highinternal dairy stocks will continue to constrainexpansion over the medium term. This will bean important factor that may provide other dairyproducing regions, which are not as heavilyexposed to grain prices, a key advantage toattain a greater share of demand growth inemerging markets. Source: USDASouth AmericaOne possible region which can sustain long-term New Zealanddairy production growth is South America. South Along with Australia, New Zealand dairyAmerica is endowed with generally ample feed production can be characterised as agrain and oilseed supplies, low labour costs, deregulated, export-oriented, grass-fedand vast grasslands which can support larger production system. In fact, New Zealand is theand more productive dairy herds. In fact South dominant milk exporter in the world marketAmerican countries, like Brazil, are increasing per accounting for 34 per cent of world dairy trade incapita dairy consumption at a rapid pace. 2010.56 New Zealand has been one of the onlyThe South American dairy markets are largely countries in the world to expand milk productionbalanced with production increasing to supply throughout the global financial crisis of 2008-the fast growth pace of domestic milk demand.52 2009 thereby continuing to entrench its dominantThis leaves little room for exports.53 Total dairy position in global dairy trade.product exports from South America reached296,000 tonnes in 2009; only a fraction of the2.6mt of combined New Zealand and Australiadairy exports54.52. Dairy Australia53. Dairy Australia 55. USDA54. USDA 56. USDA 21

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Where can theworld expand dairy supply? Concentration of New Zealand Herd size and overall production moving higher dairy production Source: Dairy New Zealand, USDA The structure of the New Zealand dairy industry has evolved quickly into a highly consolidated system. Average herd size per farm has increased from only 154 head in 1988 to 366 head by 2008, an increase of 137 per cent. The number of herds in production in New Zealand has Source: Dairy New Zealand (2009) meanwhile remained on a steady downtrend, declining 21 per cent between 1988 and 2008.58 New Zealand dairy herd growth has remained on a steady uptrend for many years. Between Increasing consolidation and 2000 and 2010 New Zealand expanded its dairy efficiency gains in New Zealand cattle herd by 28 per cent to a record high 4.5m head.57 Milk production has also remained on a steady uptrend increasing 36 per cent over the same period. Although New Zealand’s annual milk production per cow remains low compared to other major dairy production regions at only 3.7t/head compared to the world average at 3.5t/ head and the US at 9.5t/head, New Zealand’s dairy sector is still highly competitive. Its low-cost grass feeding production system has effectively insulated the industry to a large degree from swings in global grain prices over history. Source: Dairy New Zealand These industry dynamics, within the context of a deregulated, export-led dairy market have produced efficient economies of scale and allowed New Zealand dairy farmers to secure a place among the world’s largest milk exporters.22 57. USDA 58. Dairy New Zealand

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New Zealand’s total dairy product exports In Australia the dairy industry comprises a largeslumped in 2008 and 2009 from the all-time proportion of the rural economy. Measured inrecord highs established in 2007. Export volumes value of production, dairy comprises roughly 10declined 11 per cent between 2007 and 2008 per cent of the agricultural sector in Australia,but quickly stabilised into 2009 with a growth or $A3.8 billion in 2009.59 Dairy production israte of eight per cent year-on-year. For the 2010 centred in the southeast corner of Australia, in theseason, New Zealand dairy exports rose to states of Victoria, Tasmania, and South Australia.2.1mt, up 21 per cent over 2009. The trajectory These areas combined comprise 80 per centof consolidation and improving productivity per of national dairy output.60 Dairy production iscow will mean New Zealand will likely maintain concentrated in these coastal regions as thesesolid production and export growth over the areas generally received higher amounts offoreseeable future. natural rainfall.New Zealand dairy product exports Dairy producing regions of AustraliaSource: USDAAustraliaDespite producing a small proportion of the world’stotal milk supply, Australia is among the world’smajor players in global dairy trade. This role as Source: ABARE (2010)major dairy supplier to the world is expectedto increase over the coming decades. Dairy Due to the warm climate and abundance of pasturefarmers in export-oriented regions have generally lands, Australia is well suited for dairy farming. Thisfared better during world economic slowdown favourable combination of natural resources meanscompared to regions focused on maintaining an that the Australian dairy industry is predominantlyinternal dairy supply and demand balance. The pasture-based which results in an efficient, low-deregulated dairy industry in Australia has enabled cost milk production model when compared togreater flexibility to adapt to changing global many other major dairy producing countries (EUmarket dynamics and capitalise on growing import and US).61 Only two per cent of the Australian dairydemand from Asia. Certainly the geographical sector operates as complete feedlots while overproximity to these major import markets is a key 75 per cent utilise some proportion of both pasturereason for this competitiveness. Australia is also and supplementary feeding.62less exposed to high international grain prices dueto a low-cost production model based on a highproportion of grass-feeding operations. 59. ABARE 60. Dairy Australia 61. Diary Australia 62. Dairy Australia 23

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Where can theworld expand dairy supply? The dairy industry is a significant contributor Total Australia milk production to overall Australian agricultural earnings Source: ABARE Source: Australian Bureau of Statistics Australian milk production peaked in 2001 at 11.3 The Australian dairy market has been gradually billion litres shortly after the market deregulation deregulated since July 2000 leading to a program was initiated. Drought and market rationalisation and consolidation of the sector over consolidation since then have led to a decline in the past decade.63 This has aligned international milk production into 2009. Australia’s dairy herd dairy prices with those received by the Australian fell by 26 per cent between 2001 and 2009 with farmers and has resulted in a highly cost-efficient total milk production declining 20.5 per cent over production system geared toward the export this period. Poor pasture conditions and high markets. This has decreased the number of farms feed costs contributed to this herd liquidation but increased farm size and efficiency.64 Indeed, however, improving productivity also played a the structure of the Australian dairy industry is role. Through consolidation and efficiency gains, changing rapidly. The number of dairy farms Australian producers have been able to steadily operated by a single person only or with a partner push up milk yields per cow. In 2000, the average (typical family farm) has fallen rapidly from 43 per milk yield per cow stood at only 4,800 litres/ cent in 2007 to 28 per cent by 2009.65 Between cow, but has since increased 15 per cent to just 1991 and 2007 the number of dairy farms in under 5,700 litres/cow by 2010.67 This means Australia declined by approximately one third.66 that through flexibility in supplementary feeding Over the same period, the number of cows per rations producers have been able to increase milk farm also increased significantly. production in 2010 despite no significant increase in dairy herd numbers. Providing there is a return of ample rainfall across eastern Australia in the 2010 season the dairy herd size should begin to stabilise and slowly increase in 2011. Additionally, ample feed supplies should also allow milk output to make steady gains. Over the longer term, Australian dairy producers still have room to increase productivity per cow. Average annual milk produced per cow in Australia by 2009 had reached 5.8t/head compared to 3.8t/head in 1990.68 This suggests that Australian producers have managed to increase productivity rates at one 63. Dairy Australia 64. ABARE24 65. Dairy Australia 67. ABARE. USDA 66. ABARE 68. USDA

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of the fastest rates of any major dairy producing are expected to increase another 3.6 per centregion. Thus, even though Australia maintains a in 2011, and thereafter maintain a solid uptrendgrass-based production system, productivity is into the end of the decade.71 Indeed, Australia isincreasing very quickly through improvements expected to be one of the principal beneficiaries ofin herd management and strategic use of feed growing milk product demand throughout Asia.supplements. Clearly, if the economics work forfeeding more high protein feeds as supplement to Total value of Australian milk exportspastures, the Australian dairy sector can continueto boost productivity levels going forward.Australia dairy herd declining into 2009, butproductivity continues higher Source: ABARE Judging from the demand analysis provided in this report incremental supply growth from Australia will be required longer term. With the slowdown in milk production throughout most major producing countries into 2010, higher feed prices and potential for market liberalisation, it is importantSource: ABARE for Australia to provide efficient supply growth. As milk demand continues to recover in the developedAustralia also has the advantage of well economies and accelerates in developing countries,developed export markets throughout Asia. Japan Australian dairy producers are well placed to seizeremains the largest buyer of Australian dairy the opportunities that will arise.products accounting for 51 per cent of Australia’scheese exports and four per cent of SMP exports Australia dairy product net tradein the 2008/09 season.69 Other major buyers ofAustralian dairy products (SMP, WMP, cheeseand butter) include China, Malaysia, Philippines,Singapore, Thailand and Saudi Arabia.Australia’s milk product exports have declinedover the last decade along with the drought-induced dairy herd reduction. Total net-trade ofdairy products in Australia declined 40 per centbetween 1999 and 2008.70 However, there aresigns that this trend is beginning to turn around.According to FAPRI’s latest figures net dairy tradeincreased 5.8 per cent into 2009 and anotherseven per cent in 2010. Projected net exports Source: USDA, FAPRI forecasts69. ABARE 2570. FAPRI 71. FAPRI

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Conclusion Demand for dairy is expected to grow due to increasing population, rising gross domestic product (GDP), income growth and increased urbanisation. These factors are leading to changes in diets and increased consumption of dairy products. In addition, the nutritional benefits of dairy are also driving demand as consumers and governments in developing countries are becoming increasingly aware of these benefits and are starting to promote the consumption of these products. Export focussed countries, such as Australia, are well placed to benefit from this increased demand, in particular the growing demand from South East Asia. While there are a range of factors driving demand for dairy products, supply must increase to meet this demand. Supply challenges include the increased cost of production, quality of products, few surplus producing countries surplus producers and reduction of herd sizes. The majority of countries have dairy supply deficits with only a handful of countries being surplus producers including Australia and New Zealand. Australia has the benefit of a mature, well established dairy industry, trade relationships with key growing markets and is also recognised as a reliable source of quality products. The structural changes occurring in global dairy markets have seen international dairy product prices break through $2,000/t, with this price level effectively becoming the new floor post-2007. It is anticipated that the return of dairy demand growth will continue, in turn leading to growth in supply constraints to the global market and enabling surplus producers to take advantage of these conditions. Global dairy production cost comparison26